Defense Stocks on the Chopping Block

Watch out for defense cuts to put pressure on stocks in that sector, writes Jon Markman of Trader’s Advantage.

Some of my sentiment yardsticks suggest that after the recent run higher, stocks could either move sideways for a few weeks, or turn down in a mild way, for as long as three or four months.

I wish that I could be more precise, but the bottom line is that while valuations are not extremely high, they are also not extremely low, a condition that puts trading in something of a no-man's land.

The main difference between now and this time last year is that most of the macro risks to business activity and capital markets have receded. The sovereign bond troubles of Europe are not over, but neither are they the same high risk they were last year at this time. And the fiscal cliff in the United States is not completely gone either, but the “sequester” issue that looms on March 1 is a much smaller concern than it was at the end of December, when it involved tax concerns as well.

The fact that roadblocks are gone confirms that the four-year-long bull market that started in the panic lows of 2009 should continue. But this does not mean they have to continue at the same breakneck pace seen in January.

Certainly, the good news is that the economy is healing. 2013 might be an up year for GDP again, but it will be painfully slow as companies continue to keep spending and hiring under control, due to relatively soft revenue trends. They will be helped by super-low interest rates and stable inflation expectations, but there is still too much debt and too many off-balance sheet obligations to allow companies to open up the spending spigot.

The challenge for governments, businesses, and families now is to reduce their debts while still finding ways to expand and grow. Despite having the world's largest economy and key reserve currency—on the government side—the US faces the risk of another downgrade in its sovereign credit rating. While on the business side, companies will face the challenges to their growth profiles.

The sequester was designed as a sledgehammer to force Congressional leaders to negotiate deficit reductions. This looks less likely now, as without bipartisan agreement, a sizable cut in defense spending is likely.

This is one reason that I have recommended a short position in defense contractor Alliant Techsystems (ATK), as it is almost fully dependent on Pentagon spending, unlike other contractors like Lockheed Martin (LMT) and General Dynamics (GD), which have private-industry business as well.

With fiscal policy tightening up on government spending, the burden of expansion has fallen to the Federal Reserve. It has reiterated its commitment to near-zero interest rates, which is fine, as far as that goes. But no one really knows how this will affect business and consumer spending patterns, as it is the first time this has been tried to such an extraordinary extent in at least 300 years.

What we do know is that the expectation of long-lasting, low-interest rates has pushed investors further out on the risk spectrum in the search of higher returns, plowing so much money into equities, as returns in the government and even investment-grade bond market are a joke.

For now, the low rates have led companies to restock their cash hoards, leading them to rock-solid balance sheets, strong free cash flows, high relative dividend yields, low dividend payout ratios, tons of stock buybacks, and a pickup in merger and acquisition activity.

These elements, created by extraordinary monetary policy, have led to higher stock prices. And in turn, nothing fosters confidence in stocks more than higher prices. The Fed wants a stronger stock market because it believes this will lead to higher consumer confidence, and thus more consumer spending, and thus higher earnings at companies, and then higher GDP.

We all naturally hope this chain of expectations works. But markets have a habit of surprising investors at the least opportune moments. One of those could be coming soon.